Counting the Costs When Purchasing a 25-Year or Older Building - Part 2

Posted by Charlie Dunlap on Feb 22, 2019 12:38:01 PM
Charlie Dunlap

Counting the Costs of Older BuildingsIn Part 1 of this series, we discussed what the useful and physical life of a commercial building is, as well as the five stages of a building's life.  In this article, we will explore some of the factors that can decrease the physical and useful life of a commercial building. We will also touch on building obsolescence, which can be a major threat to older buildings.

Things That Could Have Accelerated the Building’s Physical Deterioration, Shortened its Useful Life, and Reduced its Value

Maintenance and Quality of Installation:
The most important factor to enable a commercial building to reach its 50-year anniversary and remain in reasonably good shape is the owner’s strict adherence to a maintenance and replacement schedule.  Building management experts can accurately schedule what major replacements and work will need to be done and at what stage in the life span of your commercial or industrial property.  They have the ability to include specialist sub-consultants to provide detailed schedules—and in many cases, costs—on all electrical, conveying, and mechanical services.

Unfortunately, not all buildings are run this way and, as a result, the durability and longevity of the building’s important components, and the serviceability of the building, are hurt.  The result is a decrease in the commercial value of the building.

If a high standard installation and quality control were not executed, then the life expectancy of the building with be shortened.

Hours of Operation:
The 50-year life span of a commercial building is based on a normal work week, which is 12 hours per day, five days per week, and 8 hours during the weekend.  If the building operated 24/7, then it will have a much shorter life expectancy.

Vacant Buildings & Internal Environment:
Vacant, unoccupied buildings deteriorate due to lack of inspections and attention to regular servicing of plumbing, mechanical, and electrical equipment.  In order for a commercial building to maintain its 50-year life span, the internal environment would need to be dry and free of corrosion.

External Environment:
The external environment surrounding a building will certainly take a toll on its life expectancy.  If the commercial property is near the ocean, then it will have been exposed to the salt air.  If the building is close to motorways or airports, it will have been exposed to harmful pollutants.  Heavy snow and ice can create potential hidden cracks that, if unnoticed, will eventually cause water leaks.

Change in Building Use:
The life span of a commercial building can be adversely affected if it is being used for something besides what it was actually designed for.  For example, the use of heavy machinery in a building that was not structurally designed for the use of heavy machinery could compromise the integrity of the building. 

Need for Newer Technology:
A building’s installed equipment or systems may no longer be supported by manufacturers because the technology has become obsolete and the cost to change to new equipment is prohibitive.

It's important to investigate each of these possibilities prior to completing an estimate of your “go-forward” capital renewal investment budget. 

Physical Deterioration - Things That Can Be Corrected and Those That Can’t

Physical deterioration is commonly referred to as a property’s “wear and tear” or “decay.”  This deterioration normally affects the building’s ability to generate cost-effective revenue.  And any loss of revenue reduces the value of the building.  It’s important to recognize the difference between curable and incurable building defects.

Some physical deterioration is curable when it is economically feasible to repair.  What makes a repair economically feasible is when the cost of repair is less than the resulting increase in value.  Painting a building is something that typically can add more value than it actually costs.

However, a building may have a defect that cannot be cured or that it is not financially practical to overcome, such as a defect in design or the “bones” of a building.

Anyone intending to purchase a building should prepare a Building Physical Deterioration Analysis as part of the due diligence process.

Even Before Reaching a Building’s Anticipated Life Span, Factors of Obsolescence Can Occur

When Older Buildings Become ObsoleteThe word obsolescence is the noun form of the more common obsolete, meaning "something no longer used." Both words stem from the Latin obsolēscere, which means, logically enough, "to fall into disuse."

Obsolescence is a serious threat to older properties because it signals the end of the life span of buildings.  Numerous older housing blocks have been knocked down because of being obsolete.  There is a general understanding that buildings, like machinery and durable consumer goods, should be replaced when they become obsolete. (1)

There are three types of obsolescence that must be understood to be recognized: (2)

Functional Obsolescence:
Functional obsolescence occurs when a property loses value due to its architectural design, building style, size, outdated amenities, local economic conditions, or changing technology.

When used in real estate, functional obsolescence is a reduction of an asset’s usefulness or desirability because of an outdated design feature that cannot be easily changed.

Economic Obsolescence:
Economic obsolescence occurs when a property loses value because of external factors such as local traffic pattern changes or the construction of public nuisance type properties and utilities such as county jails and sewer treatment plants on adjoining properties.

Economic obsolescence is a form of depreciation caused by factors that are not on the property, in the property, or even within the property lines.  It can be caused by factors like the neighborhood experiencing a rise in crime.  It can also be caused by economic factors such as problems in the job market. 

Physical obsolescence:
Physical obsolescence occurs when a property loses value due to gross mismanagement and physical neglect resulting in deferred maintenance that's usually too costly to repair.

Just as with the Building Physical Deterioration Analysis mentioned earlier, anyone intending to purchase a building should prepare a Building Obsolescence Analysis as part of the due diligence process.

Summary

Older buildings can be excellent investments if you take the time to fully understand:

  • The building’s previous ownership, maintenance, and capital renewal investment history and its impact on your future decisions and budgets
  • Where, at the time of purchase, in the building’s “cost-effective revenue generating” useful life cycle it is located
  • The costs involved in bringing the building to a position that it can be operated as an improved “cost-effective revenue generating” building
  • The costs involved in keeping the building in a “cost-effective revenue generation” position
  • The need to hire or provide the proper attentive and experienced management needed to successfully operate an older building
  • The need to plan for a holding period which will allow you to exit the investment well ahead of when the building approaches functional or economic

Be sure to read Part 3 of this series, where we discuss the economic useful life of residential rental properties (particularly apartments) and special considerations for purchasing these types of structures. 

Related Articles:
Footnotes:
  1. Andre Thomsen & Kees Van Der Flier, Obsolescence and the End of Life Phase of Buildings, Management and Innovation for a Sustainable Built Environment, Amsterdam, The Netherlands, June 20, 2011
  2. Thomas Lucier, How to Make Money with Real Estate Options: Low-Cost, Low-Risk, High-Profit Strategies for Controlling Undervalued Property...Without the Burdens of Ownership, June 29, 2012

 

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Charlie Dunlap
Written by Charlie Dunlap

Charlie Dunlap, a former partner of Trammell Crow, is the Founder and Chairman of RRA Companies. His more than 50 years of experience in the industry has involved the development, construction, rehabilitation, and management of assets valued at more than $2 billion. He has developed, built, or rehabilitated more than 10,000 housing units, managed over 11,000 apartment units, and managed or developed industrial, office, and retail properties in excess of half a million square feet. Mr. Dunlap has been named the Arizona Certified Property Manager of the Year and was presented with the Phi Epsilon Professional Award from Arizona State University.